Consumer Protection / Mandatory Disclosure

Background

Why Mortgage
Borrowers May Need Protection

Mortgage
borrowers transact infrequently, in some cases only once in a lifetime, which
means that (unlike purchasing cheese) they do not have an opportunity to learn
from experience. Because the transaction amount is large, furthermore, the cost
of a mistake is extremely high.

The
likelihood of mistakes, furthermore, including deliberate ones induced by
unscrupulous loan providers, is high. This reflects the complexities of the
transaction, and the fact that the loan provider understands them a lot better
than the borrower – a condition referred to by economists as “information
asymmetry”.

In
most mortgage transactions, the lender writes the contract, and often the
borrower doesn’t see it until the closing. Many of the contract provisions are
complicated and difficult for borrowers to understand. Mortgage pricing can
also be complicated, including multiple lender fees as well as interest rates
subject to adjustment. There may also be fees charged by third parties involved
in the transaction.

In
addition, because mortgage transactions take a lot of time, the borrower
scheduled to close on the purchase of a home reaches a point of no-return with
a mortgage lender when there is no longer enough time before the closing date to
find another lender. That leaves the borrower committed to the home purchase
entirely at the mercy of the lender.

Imperfect
Markets Versus Imperfect Government

The
fact that consumers are not being well served by an imperfect market is a necessary,
but not a sufficient condition for justifying intervention by Government. Governments
are also imperfect, and the remedies they bring to markets may be worse than
the disease. Sometimes, furthermore, markets will cure themselves in time if
Government stays out of the way.

The
case for intervention, therefore, should be based on a considered judgment that
the market will not fix the problem itself, that intervention will
fix the problem, and that the new problems created by the intervention will be
less serious than the one that has been fixed.

Alternative
Modes of Protection
Governments
have attempted to protect mortgage borrowers in any or all of the following
ways:

Disclosure Rules, where Government stipulatesinformation that
must be disclosed to borrowers, and how and when it must be disclosed.

Price
Controls,
where Government sets maximum mortgage prices.

Underwriting
Controls,
where Government sets limits on lending terms.

Contract
Controls, where Government rules what must be, and what cannot be in a mortgage
loan contract.
PART

Mandatory Disclosures

TheCase For
Mandatory Disclosure

Market-oriented economists opposed to all
types of government regulation usually make an exception for markets
characterized by extreme information asymmetry. It
is well understood that markets don't work well when one party to transactions has vastly more information than the
other.

Because mandatory disclosure is designed to
make markets work better, it is viewed much
more favorably than price controls, which distort the allocation of credit; or
contract controls, which reduce the options available to consumers.

The home mortgage market is a
textbook case of information asymmetry. One
party is in the market continuously, the other very infrequently -­sometimes only once or twice in a lifetime.
Furthermore, transactions can be extremely complex. There may be multiple
instruments from which to select,
multiple options with each instrument, complex pricing arrangements, and
frequent price changes. For the borrower, there may be a lot to learn and very
little time in which to learn it.

To be sure,
complexity varies greatly from one country to another -- the US has the most
complexity by far. Many other countries are moving in the same direction, however, propelled by the same forces
that have operated in the US: the development of secondary markets
and increasing competition. In the European Community, integration is
intensifying these pressures. Countries
moving rapidly toward greater complexity in their home loan markets, and
therefore toward greater information asymmetry, will need to consider mandatory disclosure.

Limiting Mandated Disclosures

Perhaps the most important principle for
making disclosure policy effective is that the number of items that must be
disclosed be limited to 10 per day. If the process extends over 2 or 3
days, the number of mandated items can be
increased to 20 or 30. I will explain where these numbers come from shortly.

The rationale for this rule is that consumers
have a limited attention span. If you feed them too
much at one time, they can't absorb it. Disclosures in the US are so voluminous that for most borrowers they are
useless. Disclosing everything has much the same effect as
disclosing nothing, since most people will
absorb nothing.

Beginning in 1998, I began writing a newspaper
column on mortgages that invited questions from readers. I have
fielded about 12,000 questions since then, and one
recurs with amazing frequency: "Why wasn't I told about...?" The content of the question varies over time, e.g.,
in 2002 it was mostly about prepayment
penalties. But the question usually applies to something that was in fact subject to mandated disclosure,
as prepayment penalties are.

Every
borrower in the US receives a Truth in Lending (TIL) disclosure that reveals whether or not the loan has a prepayment penalty.
But this critical item is shown in the middle of a large form full of other
information, some of it distracting, most of
it useless. Further, the TIL is received by the borrower on the same day
he receives multiple other disclosure forms.

As far as the regulator and the lender are concerned, disclosure
about a prepayment penalty is made when the
borrower receives the TIL. Yet a large percentage of borrowers in fact don't
know whether or not they have one. Mandated disclosure is ineffective because
of information overload.

Where did I get the 10 items of information
referred to earlier as the limit on disclosed
items? From my crystal ball. The correct number may depend on the nature of the disclosed item and many other factors,
some of which will vary from country to country. I'm not trying
to sell that particular number. I'm trying to
sell the idea that there should be such a number.

Setting limits means setting priorities. As a
general matter, setting the number low and
selecting the most important items increases the probability that those items
will be effectively disclosed. As the number of disclosed items increases to
include items of less importance, the probability that the most important items
will be effectively disclosed declines.

A reader has pointed out to me that some
borrowers could extract what they need from the most overblown set of
disclosures, suggesting that I have overstated the
case. I don't agree. Borrowers who know what to look for don't need mandatory disclosure; they can get the
information they want by asking for it. Mandatory disclosure is for
borrowers who don't know what to ask for, and therefore don't know what to look
for in voluminous disclosures.

Fixing Responsibility

Responsibility
for mandatory mortgage disclosures should be lodged in one agency. That agency
can be held accountable for the results, whereas if there is more than one agency involved, none of them will
be fully accountable.

With multiple agencies, furthermore, limiting
the number of disclosure items will be extremely difficult. Neither agency is
likely to consider the impact of the other on the borrower's
capacity to absorb information. If the agencies are
required to consult, expect a turf war in which each is convinced that its items should have priority. In
addition, divided responsibility may lead to competing
disclosure formats, which confuse borrowers.

In the US until very recently, responsibility was
divided between the Federal Reserve System (FRS), and the Department of Housing
and Urban Development (HUD). Divided responsibility seemed early on to be a completely
logical solution to two different problems. One problem was a wide diversity in
the way in which the cost of credit was calculated and reported between
different types of credit, and by different lenders in the same market. The legislative remedy, called
"Truth in Lending" (TIL), applied to all
consumer loan markets, not just home mortgages. It was natural to delegate
regulatory responsibility to the FRS, which, as the central bank, had broad
responsibilities for all loan markets.

The second
problem was a series of abuses in connection with real estate settlement
charges. The legislative remedy, called Real Estate Settlement Procedures Act
(RESPA), pertained only to real estate markets. Hence, it was natural to
delegate regulatory responsibility to HUD, which was the principal Federal
housing agency.

But the price
of divided responsibility was an ineffective disclosure system. Each agency developed its own disclosure form, without any consultation with the other. The
total number of items on both forms was grossly excessive, with useful
information intermixed with useless information. There was no way for a borrower to reconcile the information on the two forms.

The system of divided responsibility ended in 2012 with
the creation of the Consumer Financial Protection Bureau, which took over
responsibility for all mortgage-related disclosures.

Disclosing the Cost of Credit

The cost of
credit is the centerpiece of mandatory disclosure. A critical requirement for effective disclosure of credit cost is
comparability. A quoted credit cost of "6%" by
lender A should mean the same thing as a 6% quote by
lender B. Further, the true cost of a 6% mortgage should be identical to that of a 6% automobile loan and a 6%
personal loan.

Conceptual uniformity: One requirement of comparability is conceptual uniformity. The most widely used concept for measuring
interest cost is the internal rate of return (IRR). On a mortgage, the IRR is
(i) in the equation below:

Expressing all interest cost quotes as an IRR
creates comparability across a wide range of methods that have been used
historically to calculate interest payments. For example, in the US a 6% home
mortgage refers to an instrument on which interest each month is calculated by
multiplying .5% (1/12 of 6%) by the balance in the preceding
month. Assuming F is zero, the IRR on this mortgage is 6%.

A 6% 3-year consumer loan, however, refers to
an instrument on which interest is calculated by multiplying 6% times the loan
amount times 3. The IRR on such a loan, assuming monthly payments equal to the
loan amount plus interest for 3 years divided by 36, is
11.09%. The quoted rates mean different
things but the IRRs are comparable.

Similarly, in some countries, mortgage
interest may be calculated quarterly, semi-annually
or annually. The IRRs on 6% mortgages in these cases are 6.02%, 6.04% and 6.09%, respectively.

Period Over
Which the IRR is Calculated: If a loan
includes upfront fees, the IRR declines with the passage of time.
For example, on a 6% 30-year loan of
$100,000 with $4,000 in upfront fees, the IRR is 6.39% when calculated
over the entire term. But if the balance is paid in full after 10 years,
the IRR is 6.58%, and if full payment occurs after 5 years it is 6.98%. Which is the proper
IRR?

This is not an academic question. Suppose a
borrower was trying to choose between the loan above, and a 6.5% loan with no fees. The IRR on this loan is 6.5% regardless of when the loan is paid off, but
whether this is higher or lower than the IRR on the first loan depends on when
the other loan is paid off.

In mobile
societies where few loans run to term, this is a major problem. The optimal way
to handle it is to calculate the IRR over the period requested by the
individual borrower. When generic IRRs are shown, as in media advertising, they
could be shown at term and for 1 or 2 shorter periods.

Nominal Versus
Effective: The IRR is a "nominal" rate because
it does not take account of monthly compounding. The "effective" APR
on a 6% monthly payment mortgage with no fees, that does take account of
monthly compounding, is 6.17%. In principle,
it would be better to express all rates as effective rates because it would
provide comparability between monthly and weekly or biweekly payment mortgages.
As a practical matter, however, the differences are too small to justify the
added complexities.

Definition of Fees: The fees that
should be included in the IRR are those that would not arise in an all-cash
transaction. All fees associated with arefinance should be included, but on a purchase transaction fees that would arise if the borrower paid cash should not be.

The fees should include payments to the lender of any
type, plus payments to third parties providing services required by the lender
as a condition for granting the loan. These include reporting on the credit
history of the applicant, appraising the property, verifying and perhaps
insuring the validity of title to the property, and insuring the mortgage. All
such third party charges are part of the cost of credit and will be paid for, directly or indirectly, by the borrower.

A
possible exception is fees paid to governments in connection with the loan, for
example, a stamp tax or mortgage recording
tax. Since these fees are outside of the lender's control, it doesn't make any difference
whether they are included or excluded from the IRR so long as treatment is
uniform.

Disclosure of
Other Contractual Provisions

Mandated disclosure also should include
important provisions that may vary from loan to
loan and that may be disadvantageous to the borrower. Examples include prepayment
penalties, restrictions on assignability, late charges, and the right of the
lender to call the loan. The list of such features is likely to vary greatly
from one country to another.

Contractual provisions that are standardized
by law or custom, or that benefit the borrower,need not be a part of mandatory disclosures.

Testing Disclosures With Borrowers

The agency with responsibility for mandatory
mortgage disclosure should be required
to test disclosure forms with borrowers for effectiveness. If not required to do this by law, the natural inclination of a
disclosure agency is to check only its political constituencies. These might
include, for example, lenders, developers, and community groups, but not
borrowers.
Since the
agency responsible for disclosures is not likely to have the skills needed for
testing effectiveness, there is much to be said for mandating that the agency contract with a private firm to do this work.
The firm would be charged with determining the extent to which borrowers understand
and digest the information disclosed, and also whether the proper information
is being disclosed. Since markets, instruments
and contracts change over time, the
review function should be repeated periodically.

Price Controls

Mortgage
prices include the interest rate which is paid over the life of the mortgage,
and fees paid upfront to the lender and to third parties involved in the
transaction. Adjustable rate mortgages may have other price components, such as
a maximum lifetime rate and/or a maximum rate change.

Controls on
Interest Rates

Government
imposed price controls almost always take the form of a maximum interest rate.
In theory, if the market power of lenders maintains market rates above what
they would be under competition, Government could make the market work better
for borrowers by setting a maximum rate equal to the competitive rate. But this
would require that Government have the knowledge and tools needed to determine the competitive
rate, the discipline required to apply this knowledge consistently, and the
flexibility to adjust the rate as needed, which could be daily. This is too
much to expect of government.

More
likely, government will set the rate too low, resulting in few loans being
made, or too high which may result in market rates higher than those that would
have prevailed otherwise. So long as there are multiple loan providers that
borrowers can shop, Governments should leave the interest rate unregulated.

Controls on
Lender Fees

Shopping
is less effective if borrowers have to concern themselves with differences in
lender fees as well as in rates. The worst of all worlds for borrowers is the
practice of charging different fees for different services, which are not fully
disclosed until the borrower is well along in the transaction.

Government
can easily take fees out of the picture by setting a single charge for all
lenders. This would allow borrowers to shop the interest rate. A second best
would be to require that every lender post one price covering all their
services. Borrowers would then have to consider differences between lenders in
fees as well as in rates, but at least they would know what these are upfront.

Controls on
Third Party Charges

The
mortgage process may involve services contributed by third parties, such as appraisals,
credit reports, title insurance, flood insurance, mortgage insurance, and
closing/recording services. Borrowers will be over-charged for these services
if they are required to pay for them. If lenders are required to pay for these
services, passing the cost along in their rate and fee, it will cost borrowers
less.

Lenders
pay less for third services than borrowers. Lenders purchase in bulk and are
knowledgeable purchasers, borrowers aren’t. When lenders purchase, the service
providers must compete in terms of price. When borrowers purchase, they rely on
the lender to select the service provider, who compete for referrals from
lenders. This is sometimes referred to as “perverse competition” because it
raises prices rather than lowering them.

Bottom
line: Government should require that any service required by a mortgage lender
as a condition for the granting of a mortgage must be paid for by the lender.

Underwriting Controls

Loan
underwriting is the imposition of a set of requirements for loan approval
designed to minimize risk of loss from borrower default.

Requirements that the borrower
have sufficient income relative to their current and prospective debt payment
obligations are designed to assure the borrower’s capacity to repay the loan.

Requirements that the borrower
have a credible history of meeting obligations are designed to assure that the
borrower is willing to repay.

Requirements that the property
have value in excess of the amount borrowed are designed to assure that in the
event that the borrower does default, sale of the property by the lender will
cover all or most of the amount owed.

As
a general rule, lenders protect themselves against loss very well and there is
no need for government involvement. Indeed, Governments often view private
lenders as excessively cautious, denying credit to many worthy applicants. This
has been the rationale of many special loan programs supported by government
that offer less restrictive underwriting rules.

But
there is one important exception. During a housing bubble, in a system in which
mortgage lenders securitize mortgages for sale to investors, underwriting
restrictions that are not constrained by Government may be unduly liberalized.
Rising home prices induce investors to overlook underwriting deficiencies. This
is what happened in the US during the period 2004-2007, and when the
house-price bubble burst, investors all over the world were burned.

But
this is a cyclical issue, as opposed to a structural one, and does not call for
a permanent set of Government-imposed underwriting restrictions. Rather, the
appropriate remedy is stand-by authority to impose such restrictions when
circumstances make them necessary.

Contract Controls

Since
lenders typically write mortgage contracts, it is not surprising that the
contracts are structured to serve lender interests. But this is as it must be
to induce lenders to lend, and the only rationale for Government involvement is
where a contractual provision is abusive and unnecessary. An example is a
provision that gives the lender the right to demand immediate repayment for any
reason.
A
number of contractual provisions have valid uses but could be abusive if
borrowers receive no benefit from them or are not fully aware of them when they
sign on. For example:

A balloon provision requires the
borrower to repay the loan balance at the end of some specified period that is
shorter than the term, allowing the lender to reduce interest rate risk. It
shifts that risk to the borrower, who must pay the current market price to
extend the loan.

A prepayment penalty requires the
borrower to pay a penalty for early repayment of the loan balance, partially offsetting
the loss of income that results from early repayment. Such a penalty can make a
refinance unprofitable for the borrower.

A provision for negative
amortization allows the borrower to make monthly payments that don’t fully
cover the interest due, resulting in a rise in the loan balance. Lenders do
this to expand their market and borrowers are enabled to purchase houses they
could not otherwise afford.

All
of these provisions have been made illegal at one time or another in some
jurisdictions. The first two are often considered unfair to borrowers, without
necessarily considering whether borrowers received a quid pro quo for accepting
them. The third is considered dangerous to the borrower because of the rising
future payments that result, without necessarily considering whether the
borrower will have the capacity to make the payments.

Because
these provisions may be useful to borrowers, good mandatory disclosure
generally is a better way of dealing with them than contract controls.

Jack Guttentag

Jack Guttentag is a Professor-Emeritus of Finance and has been a member of the faculty of the Wharton School since 1962. Dr. Guttentag is presently co–director of the Zell/Lurie Real Estate Center’s International Housing Finance Program.